Liquidity Ratios

What are liquidity ratios?

they calculate the ability of a firm to meet their day to day expenditure

What do liquidity ratios show?

how much money is available to pay the bills and how solvent a business is

When will a firm have poor liquidity?

when they don't have enough working capital and they can't use their assets to pay for things when they need them

What is the liquidity of an asset?

how easily it can be turned into cash and used to buy things

When is a business insolvent?

when they do not have enough current assets to pay their liabilities when they are due

What should a business fix themselves when they become insolvent?

has to either quickly find the money to pay their liabilities to give up and cease trading or go into liquidation

How can liquidity be improved?

decreasing stock levels
speeding up collection of debts owed to the business
slowing down payments to creditors

What are the two different liquidity ratios?

current ratio
acid test ratio

What is the acid test ratio?

it compares current assets (excluding stocks) to current liabilities

What does the acid test ratio?

shows how much of what a business owes in the short term is covered by its current assets

What is the equation for the acid test ratio?

(current assets - inventory) / current liabilities

What is the ideal acid test ratio?

1:1

What does a 1:1 acid test ratio mean?

that both amounts are the same

What does a value of much more than a 1:1 acid test ratio mean?

the business had money lying around that they could use more profitably if the invested it elsewhere

What does a value of less than 1:1 acid test ratio mean?

the business doesn't have enough current assets to pay its bills

What is the current ratio?

compares current assets (including stock) to current liabilities

What is the equation for the current ratio?

current assets / current liabilities

What is the current ratio also known as?

working capital ratio

What should the current ratio be?

higher than 1:1

Why should the current ratio be higher than 1:1?

to take into account whether the business needs additional capital to replace stocks as the business couldn't sell off all its stock

What are included in current assets?

cash
debtors - receivables
inventories

What are included in liabilities?

tax
creditors - payables
overdraft